From the ever readable Paul Kasriel:
"Fund managers and investors have been puzzled why prices across a wide spectrum of assets moved together last week – namely, down. I think it has everything to do with delevering. What is bringing about delevering? When a fund owns assets that are going down in value for some fundamental reason, say mortgage-backed securities whose underlying collateral are defaulting subprime mortgages, and the fund is levered, its creditors start to make margin calls. The fund, then, has to sell assets to raise cash. The fund might end up selling relatively high-quality and liquid assets [Ed: i.e., Gold, Oil] in order to raise the maximum amount of cash quickly to meet its margin call. This puts downward pressure on the prices of assets not tainted by credit risk.
Now price volatility increases in asset classes unrelated to the originally troubled asset class. Many hedge funds engage in seemingly low-risk strategies that have commensurately low returns. In order to boost investor returns, these low-risk funds incur leverage. Many of these funds measure risk by the price volatility of their asset holdings. When there has been an extended period of low price volatility, risk is considered to be low. Therefore, more leverage can be incurred. But when asset-price volatility starts to increase due to the sale of assets to meet margin calls by funds with tainted assets, funds with seemingly “good” assets are forced to delever because of the increased risk these hitherto low-risk funds now face. So, the low-risk funds end up selling “safe” assets in the process of delevering, thereby putting downward pressure on the prices of these “safe” assets.
Leverage is wonderful when asset prices are rising. It is a bear when asset prices start to retreat. It creates a vicious cycle. Both the sinners and the sacred get got in the undertow."
That last paragraph us especially sharp . . .
Diverse Asset Class Correlation and Leverage
Northern Trust Global Economic Research, August 13, 2007
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